IRS tells public utility it can issue tax-exempt refunding bonds.

WASHINGTON – The Internal Revenue Service recently issued a favorable private letter ruling that found a public power utility's contracts with other utilities, including some that were private, would not give rise to private business use that would jeopardize the tax-exempt status of refunding bonds it wanted to issue.

The IRS cautioned that private letter ruling 201727003, which was publicly issued on July 7, is only directed at the public utility, which was not identified. But several lawyers said that the letter-ruling shows flexibility on the part of the IRS and sheds light on the complex area of tax law and regulations covering public utilities, the contracts they have with other utilities and entities, and the bonds they issue.

The letter-ruilng involves a public utility that wants to issue tax-exempt refunding bonds to refund previously issued bonds and to finance capital expenditures related to a power plant. The utility issued bonds to help finance the development of three power plants, but only one was completed and put into service. Construction of another power plant was suspended and the third power plant project was terminated.

The letter-ruling also involves a distributor that blends the electric power from the public utility's power plant with other power the distributor has available to market to meet utilities' net requirement loads in the region.

The letter-ruling details several complex contracts the issuer has in place that covered the construction of the power plants as well as the sale of the electricity from the plant completed with other utilities, including some private ones. Prior to the construction of the projects, the public utility and power distributor entered into separate but materially identical contracts with certain utilities. Under each contract, the public utility was to sell a designated share of its power plants to a utility. In return, the utility agreed to pay the public utility a proportional share of the issuer's annual net costs for operation, maintenance, repairs, renewals and replacements of the related power plant, including debt service on the bonds.

Importantly, during the decades the contracts have been in place, the participating utilities conditional right to take energy from directly from the the public utility's power plant has never been exercised and the public utility does not expect any utility will ever request that power.

The public utility asked the IRS for assurance that its contracts, including any with private utilities, “do not give rise to a private business use’’ that would jeopardize tax exempt status of its bonds. It also sought assurance that the law would not require the output of its power plant to be allocated under a specific sales agreement to a specific utility. Finally, the public power utility asked if could treat the refunding bonds, which would be multipurpose, as separate bond issues.

The IRS provided all three assurances. In the ruling that there is no private use issue, the IRS said, "The chance of ant nongovernmental utility ever taking delivery of energy from the [private utility] pursuant to the utility's contract is contingent and remote."

Linda Schakel, a partner at Ballard Spahr in Washington, said in an email, "This ruling would seem to support the idea that use provided for under a contract may not need to be counted against the private business use limitation if the issuer can establish, through historical practice, that actual use under the contract is contingent and remote.","The world of utility bond issues is a rather small one and historically has had its own special rules, which in some ways are more lenient than other bond financings,'' Schakel also said in her email.

Matthias Edrich, a tax attorney at Kutak Rock in Denver, said, "The ruling went beyond the three most common methods public utilities can use to allocate bond costs for multiple projects by suggesting a fourth option not often recommended in the past. "

Utilities usually chose among three options -- allocate a piece of each bond maturity to each project on a pro rata basis, using the savings method, or using the useful life method, he said.

“But this ruling applies a fourth method and that’s interesting because there are not that many PLRs, and I can’t think of one right now, that authorize this method,’’ Erdrich said.

“If you can’t use any of the three, then you can use this fourth one as long as your state law doesn’t allow the others and as long as it doesn’t result in a greater burden on the market,’’ he said.

Nancy Lashnits, an attorney with Steptoe & Johnson in Phoenix, Arizona, said part of the value of the IRS letter is that the agency doesn’t often rule on tax laws covering bonding by electric utilities.Provided

Nancy Lashnits, an attorney with Steptoe & Johnson in Phoenix, Arizona, said part of the value of the IRS letter is that the agency doesn’t often rule on tax laws covering bonding by electric utilities.

“I wouldn’t say it’s rare, but it’s not common,’’ said Lashnits worked for the IRS from 1990 to 1997 in Branch 5, the tax-exempt financing branch for financial institutions and products in the chief counsel’s office.

“I think they showed their flexibility dealing with multipurpose allocations when it came to refunding bonds,’’ Lashnits said. “Of course, I used to work there and my view is much more the belief that the IRS tries to be flexible in dealing with issuers that come in for rulings.’’

“I think it’s a curiosity piece,’’ Edrich said, referring to the PLR. “I think it has news value in that sense. “I think it’s news because practitioners are interested in how a fourth option is applied because it’s not applied very often. But I don’t think practitioners will be able to use it in their deals for other utilities.’’

Lashnits agreed that the ruling involves a complex part of the tax code. “It’s a very complicated area of the municipal tax code and there’s not a big body of tax law that helps you wind your way through these rules,’’ she said.

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